Fidelity Frets as Banks Stretched With Guarantees: China Credit

Chinese lenders have never been so willing to guarantee corporate dollar bond sales, even as their own default risk climbs at the fastest pace in Asia.

Bank of China Ltd.’s Macau branch backed $500 million of securities sold by China Shipping Group Co. last month, while Agricultural Bank of China Ltd.’s Beijing arm supported a $300 million issue by Beijing Energy Investment Holding Co. last week. Beijing Energy priced its 2.75 percent notes to yield 186 basis points less than similar Asian debt, based on an estimate of the company’s credit standing by Nomura Holdings Inc.

Bad loans have surged to the highest since 2008 in the world’s second-largest economy prompting credit-default swaps on China Development Bank Corp., Export-Import Bank of China and Bank of China to rise the most in an Asian benchmark this year. An added risk is that the government and its lenders are forced to take on the burden of sorting out payment delays in the nation’s $6 trillion shadow banking industry.

“If the credit-support provider’s fundamentals are weakening, that should translate to a weakening in fundamentals of the bond,” said Gregor Carle, the Hong Kong-based investment director at FIL Ltd., which is known as Fidelity Worldwide Investment and which managed more than $270 billion as of Dec. 31. “Concern about what could be further down the road in China is definitely still there.”

Demand Premiums

Standby letters of credit are payment guarantees issued by a bank for a client. They provide a backstop if the client fails to fulfill a contractual obligation to a third party, such as paying a coupon or repaying principal.

Beijing Energy’s notes, along with Agricultural Bank, are rated A1 by Moody’s, the rating company’s fifth-highest grade. The supplier of heat and energy services would rate “roughly in the weak BB region” on a standalone basis, according to a Feb. 19 Nomura report. A BB rating is Standard & Poor’s second-highest junk grade.

A number of factors encourage banks to lend such support, including fees, the chance to improve client relations and the fact that “cash isn’t immediately going out the door like a loan,” said Harsh Agarwal, Singapore-based head of Asia credit research at Deutsche Bank AG. Two to three more deals backed by standby letter of credits are in the pipeline, he said, advising investors to demand higher premiums on bank-backed securities and scrutinize each structure.

‘One Brush’

“Investors and rating agencies tend to paint these deals with one brush where the bonds are rated the same as the bank providing the letter of credit,” Agarwal said. “But the structures are very different. Some letters provide for a single drawdown only, which makes them weak, while others have multiple drawdowns.” Deutsche Bank helped to arrange Beijing Energy’s sale.

Hainan Airlines Co. was the only issuer to sell a bank-backed security during the first two months of 2013, Bloomberg data show. A letter of credit from Bank of China’s Hainan branch covers the entire life of the debenture and multiple drawdowns, according to a Deutsche report from January.

Beijing Energy’s renminbi-denominated letter of credit from Agricultural Bank covers all the notes’ coupons as well as the principal, and has a two-way cross-default clause with the bank, according to Nomura’s report.

Bank of China’s support for China Shipping’s notes by contrast is only good for one payment, if required. The notes are rated A1 by Moody’s, in line with the bank.

Onshore Drought

“If the letter of credit doesn’t fully cover the principal and the interest for the full duration of the debt, we could only rate the issue based on the credit profile of the issuer,” said Ryan Tsang, a Hong-Kong based analyst at S&P. “The letter of credit wouldn’t be considered an effective credit enhancement for rating purposes.”

Total sales of offshore debt are gathering pace as onshore funding channels dry up due to surging borrowing costs.

Guangzhou R&F Properties Co. led $14.3 billion of U.S. currency sales by issuers from China and Hong Kong this year, 5 percent more than the first two months of 2013. Yuan-denominated sales this year total about 438.4 billion yuan ($71.5 billion), down from 545.6 billion yuan the period prior.

Yields on 10-year yuan bonds sold by top-rated Chinese companies rose to a record 6.43 percent on Jan. 14 before slipping to 5.92 percent as of yesterday, according to Chinabond indexes. China’s yuan dropped as much as 0.9 percent in onshore trading by 11:27 a.m. in Shanghai, the biggest intraday weakening since at least April 2007.

Credit Risk

Perceptions of risk at three Chinese lenders are deteriorating the most in Asia this year, according to the Markit iTraxx Asia index. The cost of insuring debt of Industrial & Commercial Bank of China Ltd., which isn’t in the index and is the nation’s biggest lender, has risen 32.6 basis points this year to 164.2 basis points on Feb. 27, according to data provider CMA.

Investors in a 3 billion yuan coal trust product, Credit Equals Gold No. 1, distributed by ICBC were last month bailed out days before it matured. Industrial & Commercial Bank of China Asia Ltd., an ICBC unit, provided a standby letter of credit for a $500 million 4.021 percent 2018 bond sold by China Merchants Land Ltd. on Dec. 4.

The yield premium on Bank of China’s $500 million of five-year 3.125 percent notes issued in January at a 162.5 basis-point spread has widened to 183.4. The lender has put its weight behind at least $4.5 billion of dollar bonds sold by other issuers, Deutsche Bank’s report and Bloomberg-compiled data show.

“Buyers are probably more cautious and require a bit more than they have for some time,” FIL’s Carle said. “Things like the Credit Equals Gold No. 1 trust product certainly haven’t helped.”

Before it's here, it's on the Bloomberg Terminal.